SUPPORTING ORGANIZATIONS:

A PRIMER

By MacKenzie Canter, III, ©2000
Member of VA, DC, MD and MO Bars
Copilevitz & Canter, LLC
1900 L Street, NW
Suite 215
Washington, D.C. 20036
202-861-0740

1. What is a "supporting organization" ("SO")?

A SO is a charity which escapes the restrictions of being a "private foundation" ("PF") by being affiliated with one or more "public charities."⁽¹⁾

2. Is the SO a new type of exempt organization?

No. The SO was created by Congress as part of the 1969 Tax Reform Act. See, House Report No. 91-413 (Part 1), 1st Sess., 40-1 and Senate Report No. 91-552, 1st Sess., 56-59. See, also Congressional Record, Dec. 6, 1969, Page S-15982. (The SO is seven years older than the tradition of Philanthropy Monthly conferences.)

3. Is there any limitation on the deductibility of gifts to a SO?

Gifts are deductible to the same extent as gifts made to "public charities." Generally, this means cash donations to an SO are deductible up to 50% of the individual donor's AGI. Gifts of appreciated property to an SO are deductible up to 30% of the individual donor's AGI. In contrast, the deductibility of gifts to a PF is considerably more limited, i.e., 30% limit for cash gifts and 20% limit on gifts of appreciated property. Furthermore, gifts of appreciated property to a PF in most cases are deductible only "at basis" (not FMV).The one exception to this is a contribution of "qualified stock."⁽²⁾ This means, for instance, that a gift of real estate qualifies for a full FMV-based deduction if contributed to an SO--but only a "basis" deduction if donated to a PF.

4. What about the excise taxes which apply to a PF? Is an SO subject to these taxes?

No. The onerous and confusing excise taxes of IRC §§ 4940-4945 do not apply to an SO. The following excise taxes apply to PF's:

Investment Income. Section 4940 imposes a 2% (or in some cases, 1%) excise tax on investment income.

Self-Dealing. Section 4941 imposes an excise tax on acts of "self-dealing." Acts of self-dealing include a direct or indirect sale or exchange between the private foundation and a "disqualified person," defined by IRC §4946. Other acts of self-dealing are loans; furnishing of goods, services, or facilities; and payments of excessive compensation.

Distributions. Section 4942 imposes an excise tax on the failure to distribute income. Generally, a private foundation annually must distribute an amount equal to 5% or more of the value of its investment assets.

Excess Business Holdings. Section 4943 imposes an excise tax on excess business holdings. Excess business holdings in a corporation or partnership are defined as any excess over 20% (or in some cases 35%) of voting interest reduced by the percentile voting interest held by disqualified persons.

Jeopardy Investments. Section 4944 imposes an excise tax on jeopardy investments, or investments which jeopardize the charitable purpose, such as puts, calls and straddles.

Taxable Expenditures. Section 4945 imposes an excise tax on taxable expenditures. Taxable expenditures include payments to persons or entities other than qualified charities.

None of these excise taxes hamper the operations of an SO.

5. What about UBIT?

An SO is subject to the tax on unrelated business income in the same manner as public charities. If UBIT is generated in excess of $500, Form 990-T must be filed.

6. Can the founder maintain control of an SO the way he can control a PF?

That's the one disadvantage of an SO compared to a PF--although, in practice, this disadvantage may not exist. The SO either must be controlled by the "public charities" it supports⁽³⁾ or be "operated in connection with" the "supported organizations."⁽⁴⁾ In this latter case, the board of directors of the SO need not contain any representative of the "supported organization." The board of an SO may not be controlled, directly or indirectly, by one or more "disqualified persons,"⁽⁵⁾ other than foundation managers and "supported organizations."

7. Does this mean the founder cannot serve on the board?

The founder is permitted to serve on the board. So is the founder's spouse. The only requirement is they--as "disqualified persons"-- may not "control" the board. They may hold, however, a "minority" voting position. For example, if the SO has a five person board, the founder and spouse may serve as directors. The other three board members may be friends. The board of the SO must not be controlled by "disqualified persons." This refers to voting power, not to persuasion.

8. You referred in a footnote to Type I, Type II, and Type III SOs. Explain the differences between these "types" of SO's.

The statute [IRC § 509(a)(3)] which created "supporting organizations" requires that an SO be "...operated, supervised or controlled by or in connection with..." one or more "public charities." The IRS parsed this phrase to come up with three distinct types of SO's.

Type I SO's are directly controlled by their supported organizations. Type I control exists if a majority of the board of the SO is appointed by the supported organization. Commentators have analogized Type I control to a "parent-subsidiary" relationship, with the "parent" being the supported organization.

Type II SO's may be analogized to "brother-sister" corporations. In a Type II relationship the SO and its supported organization are controlled by the same persons.

Type III SO's are quite different. As noted above, in the Type III relationship, the supported organization need not be given any power to appoint any member of the board of the SO. Nor need the SO and its supported organization have any common board members.⁽⁶⁾ In other words, "parent-subsidiary" and "brother-sister" relationships are not required for Type III SO's. Type III SO's generally are more attractive to wealthy benefactors contemplating continued involvement in the oversight of philanthropy.

Type III SO's are "operated in connection with" the supported organization (or supported organizations.)

9. Type I and Type II control seems easy enough to understand, but I'm not clear what is meant by "operated in connection with." This seems ambiguous.

To an extent it is. One federal court stated that the Treasury Regulations interpreting IRC § 509(a)(3) are "fantastically intricate and detailed."⁽⁷⁾ However, over the last (almost) thirty years, IRS rulings and judicial interpretations have helped to refine the definition of "operated in connection with."

There are several ways for the SO to meet the requirement of Type III control.

Type III SO's must pass two tests: (1) the "Responsiveness Test"; and (2) the "Integral Part Test."

The "Responsiveness Test" has two alternatives:

Alternative A: (1) the supported organization must appoint or share in common one or more board members of the SO⁽⁸⁾, or (2) the SO must establish that there is, in fact, a close and continuous working relationship between the SO and supported organization and the supported organization plays a major role in the investment and distribution decisions of the SO.

Alternative B: (1) The SO must be a "charitable trust" under state law;⁽⁹⁾ (2) each supported organization must be named in the SO's governing instruments as a beneficiary of its policies; and (3) the supported organization must be given the right under state law to enforce the "charitable trust" and compel an accounting from the SO.

Alternative B is the easier of the two to meet.⁽¹⁰⁾ As noted, under the laws of most states, any charitable nonprofit corporation is ipso facto a "charitable trust." The supported organization(s) is specified in the articles of incorporation⁽¹¹⁾ and given the power to enforce the "trust" and require an accounting from the SO.

The "Integral Part Test" also provide two alternatives:

Alternative A: The SO must perform the functions of or carry out the purposes of the supported organization. Furthermore, it must be established that "but for" the actions of the SO the supported organization would have to undertake them. This test is, obviously, rather subjective. It is difficult to prove a "negative predicate". (Some logicians say it is possible to prove a 'negative' only be eliminating all other variables. This is why statistical modeling produces 'correlations' as opposed to proofs of 'causation'.)

Alternative B: The SO must pay at least 85% of its income to or for the use of the supported organization. (85% or more is deemed to be "substantially all" of its income.)⁽¹²⁾ In addition, the "level of support" provided by the SO must be sufficient to ensure that the supported organization is "attentive" to the operations of the SO, i.e. "keeps an eye on" the SO.

10. Are there any other tests to meet?

There are "organizational" and "operational" tests which apply to all three types of SO's. These are easy to understand.

The "organizational" test is satisfied if the SO's governing instrument, e.g., articles of incorporation, (I) states that the purpose is limited to carrying out activities permitted by IRC section 509(a)(3) and (ii) specifies the public charity or charities which the SO will support. (The governing instrument should reinforce these two points by stating, conversely, that the SO is not authorized to engage in activities other than carrying out the purposes of an IRC section 509(a)(3) organization and is not authorized to support charities other than the one(s) specified.)⁽¹³⁾

The "operational" test is met if the SO's activities support or benefit the specified public charity or charities. In addition to making grants to the supported charity, the SO is permitted to make expenditures directly for the benefit of the individuals and causes served by the supported charity. The SO also may provide services or facilities to the beneficiaries served by the public charity.

The SO also operates to serve the public charity if the SO conducts fund raising to support the public charity.

11. In terms of the "organizational" test, what do you mean by "specifying" a public charity or charities in the SO's governing instrument? Does this mean the SO must identify once and for all the charity or charities it will support?

A Type I or Type II supporting organization need not designate the supported organizations by name in order to meet the specified organizations prong of the organizational test. Instead, the articles of organization of such supporting organizations may designate the supported organizations "by class or purpose." See, Treas. Reg. § 1.509(a)-4(d)(2)(i)(b).

The conservative course is to identify the supported charity or charities in the Type III SO's governing instrument. The Regulations permit a Type III SO to dispense with actually identifying one or more charities if there exists an "historic and continuing relationship" between the Type III SO and its supported charities. Obviously, in the case of a new entity, this test is difficult to meet.

A Type III SO is not permitted to change "at will" its specified supported charities. However, the Regulations permit substitution of supported charities (within the same class) if the specified charity ceases to exist or loses its exempt status.

If the Type III SO identifies more than one supported charity, the Type III SO is permitted to make unequal distributions between its supported charities. These distributions can vary from year to year, within the class of supported charities. This flexibility is, nonetheless, constrained by the requirement (discussed above) that the SO must meet the "integral part" test with respect to at least one of its supported charities. Specifically, the "attentiveness" requirement must be met.

12. Are SO's growing in popularity?

Yes. As more and more lawyers and CPA's have learned about the tax and operational advantages of an SO compared to a PF, SO's have increased in popularity. The enhanced deduction for contributions to an SO, as compared to a gift to a PF, is highly significant. For example, if John Doe paid $100,000 in 1970 for real estate (Blackacre) which is now worth $1,000,000, Mr. Doe could deduct only his basis ($100,000) if he conveyed Blackacre to his PF. If he conveys Blackacre to the SO ( of which he is chairman of the board), his tax deduction is equal to Blackacre's FMV.

There is another reason why SO's are increasing in popularity. One of the fastest growing and most popular type of public charity is the community foundation which supports many and varied causes. An SO which specifies a community foundation as its supported charity gains tremendous flexibility in distributions and range of activities. (Functionally, this flexibility is tantamount to that of a PF---but without all the PF's drawbacks.)

Another way to think of SO's is by analogy to "donor-advised" funds---with de facto control being retained by the founder of the SO. The friends and relatives of the founder may be encouraged to contribute to the SO for two reasons (1) it is a "maximum deduction donee" for federal tax purposes; and (2) they can enjoy significant input in the use which will be made of their generosity. An SO is not required to meet a "public support" test, while enjoying the same "maximum deduction donee" status of a publicly supported charity. This means, in practice, that the SO may function as a "family affair" or "exclusive club". The "intimacy" of the SO allows benefactors the assurance that their voices will be heard and respected. (They may even become board members.)

From the standpoint of the development officer or executive officer of a Section 501(c)(3) organization, he or she should be sufficiently familiar with the benefits of the SO to persuade a would-be benefactor to consider the SO option in lieu of forming a PF. The obvious attraction to the "supported" 501(c)(3) entity is the legally required "tie that binds" between the SO and the charity. The board of a PF can spread its largesse among many competitors. An SO is either married to the supported charity (in the case of Type I and Type II SO's) or living with the supported charity (in the case of a Type III SO.)

NOTE

This outline is not intended, nor is it provided, as specific legal service, but, rather, only as a general discussion of concepts and principles. Please consult with the author or another attorney before utilizing any techniques stated herein. Of necessity, this material has not addressed all issues, principles, exceptions, and exclusions which may apply to a specific transaction.

About the Author

Mr. Canter earned his B.A. at Randolph-Macon College, M.A. at The George Washington University, M.Div. at Yale and Oxford Universities, and J.D. at The University of Virginia Law School. Copilevitz & Canter, LLC with offices in Kansas City and Washington, D.C., represents over one hundred tax-exempt organizations. Mr. Canter has written many articles in the areas of charitable contributions and tax-exempt organizations law, is the co-editor for tax issues of Philanthropy Monthly and is a lecturer to state societies of certified public accountants for their CPE programs in tax law. He is a member of the bars of Virginia, Maryland, District of Columbia and Missouri.

End Notes:

1. The reference to "public charities" is to organizations described in Code § 501(c)(3) and either § 509 (a)(1) or § 509 (a)(2). The term, "public charities," is intended to include churches, universities, hospitals, museums, etc. Many of these entities must meet the "public support" tests of IRC § 509. Some, however, e.g., churches, are not required to establish "public support." A private foundation is not a "publicly supported" charity.

2. "Qualified stock" means stock traded in an established securities market. The 1997 Taxpayer Relief Act extends the termination date for the exception allowing a full fair market value deduction for contributions of qualified appreciated stock to private foundations from May 31, 1997 to June 30, 1998 [Code § 170(e)(5)(D)(ii) as amended by the Taxpayer Relief Act of 1997, §602(a).] Thus, the Act extends the exception for contributions of qualified appreciated stock to private foundations during the period June 1, 1997 through June 30, 1998. Whether this will be extended again is anyone's guess. This is another drawback to a PF.

3. Type I and Type II SOs.

4. Type III SO.

5. See, IRC §4946.

6. It may be advisable, however, as explained below, to have one common director.

7. Windsor Foundation, 77-2 USTC ¶9709 at 88, 396 (E.D. VA, 1977).

8. This option is recommended. It is "objective." Only one board member need be also a board member of the supported charity.

9. Generally, charitable nonprofit corporations are "charitable trusts" under state laws.

10. In fact, the SO could meet both alternatives A and B.

11. This is generally required, as a practical matter, in the case of Type III SO's. See, discussion below.

12. Revenue Ruling 76-208, 1976-1 C. B. 161.

13. As to "operated, supervised, or controlled by" or "supervised or controlled in connection with" organizations, Types I and II, the articles of organization meet the "purposes" prong of the organizational test if the purposes are "similar to, but no broader than" the purposes set forth in the articles of the supported organizations.